Derivatives Still Pose a Threat

Federal regulators have proposed a ruling to reduce the risk of over-the-counter (OTC) derivatives in our financial system and the general economy.

These financial instruments are used for speculation, arbitrage and hedging of production risks. Since they have no margin requirements, no funds are put aside to offset potential loses. Wall Street firms earned large profits from this activity. It was a major contributing factor to the financial crisis in 2007 and 2008.

The ruling proffered by the Federal Reserve, the Office of the Comptroller of the Currency (OCC) and other regulators falls well short in substance and too long in time to counter the potential risks to our economic well-being.

In June 1998, the face value of all global OTC derivatives was $70 trillion. Following the Clinton deregulation of derivatives in 2000, this figure skyrocketed nearly 10-fold to $684 trillion by June 2008, according to the Bank for International Settlements.

Since then, this figure has continued to rise, reaching $710 trillion by the end of 2013. U.S. bank exposure was approximately $230 trillion at the end of March 2014, according to the OCC. OTC derivatives comprise roughly 90 percent of the total market, which includes exchange-traded derivatives, such as futures and options contracts.

Despite this increase in the notional value of derivatives, proper regulation has not been established.

The Dodd-Frank Act of 2010 required that rules be approved to regulate this market adequately. A ruling was proposed in 2011, but was recently re-purposed in 2014 to reflect international derivative rules and public comments.

The new ruling would not require margin payment unless the margin exceeds $65 million, effectively eviscerating much of the margin requirement. It would also exclude non-financial companies that act as "end-users" to hedge the value of the goods they produce.

This would incentivize non-financial firms to divert trading to new dark pools or unregulated OTC venues, away from centralized clearinghouses that require margin post. Some U.S. banks are conducting their derivative trades through non-U.S. subsidiaries that do not have explicit guarantees from the U.S. parent, another way to evade the proposed ruling.

While some aspects of the rule would be implemented in 2015, the phase-in would be complete in 2019, 10 years after the inception of the financial crisis. A long time, indeed.

The implementation of this ruling would require that banks hold higher-quality assets with lower yields, which can negatively impact their bottom line. Wall Street needs to get smaller before the U.S. economy can get bigger.